15 Δεκεμβρίου 2016

The trouble with selling passports

[Accountancy Cyprus, No. 125, December 2016.]
The Cypriot economy grew at a healthy rate of close to 3% in 2016. A record year for tourism drove much of this growth. The real estate and construction sectors have also picked up significantly, thanks to a large extent to the government’s “citizenship by investment” program. The government recently touted the program’s success, claiming that it brought in €4 billion since 2013. But it also admitted that it is facing criticism from other European countries over the program and Minister of the Interior Socratis Hasicos blamed some companies he did not name for abusing the scheme and giving Cyprus a bad name.

Cyprus is neither the first nor the only country to offer citizenship or permanent residency to high net worth individuals in return for some form of capital inflow. In principle, there is nothing wrong with this idea. Offering citizenship to investors and entrepreneurs who will come in and make significant contributions to a country’s economy is certainly a worthwhile proposition.

The problem is that in practice these schemes are often attached to investments in real estate. There are several reasons why real estate investment does not bring in as many benefits as other types of foreign direct investment, such as the building of a factory or research facility, or the establishment of new company headquarters. These activities bring significant benefits in the form of high quality jobs, importation of technology and know-how, and demand for local services such as restaurants and schools. These are long term benefits that are spread widely across the population.
By contrast, benefits from real estate investment are mostly temporary and highly concentrated. They primarily benefit a small number of large property owners and developers, and to a lesser extent the lawyers and accountants who provide the supporting services. This is particularly so when the new citizens do not actually spend much time in their new country. If someone buys an expensive apartment that sits empty most of the time, there is little additional benefit to the local economy other than what the apartment’s seller receives. If many apartments in a building are empty for this reason, we end up with ghost buildings.

But the most dangerous aspect of large scale real estate investment is the creation of distortions that can be very detrimental to the objective of balanced and sustainable growth. The requirement of a minimum level of investment sets an effective price floor for high-end real estate and pushes up prices across the economy. This creates a ‘Dutch disease’ type of situation. Real estate becomes so expensive that it discourages investment in other sectors of the economy. We have seen this recently in Cyprus when two of the three candidates for the casino development pulled out, reportedly because they were unable to secure reasonably priced land.

One could argue that the program served a useful purpose as it helped clear the stock of apartments and houses that were built during the years of the property bubble. There is some merit to this argument, but the scheme should be recognized for what it is: the use of public property (passports) to bail out the country’s big developers. If the developers used the revenue to pay off their loans, then this can be said to have served a useful purpose, despite the down side in terms of inflated property prices.

Unfortunately we have now moved into the second, more dangerous phase of the program, where entire new developments are being put up with the exclusive purpose of serving citizenship seekers. This benefits developers and the construction sector, but at the cost of even greater economic distortions: in the short-term the citizenship program was distorting prices, in the long-term it distorts investment. Productive resources are being put into use to create developments that only have value because of the citizenship scheme. If the scheme goes – which is likely given concerns expressed by the European Commission and the OECD, among others – then the investments will be stranded.
Citizenship is a public good. If a country wants to sell it, it should so in way that distortions are minimized and as many people as possible benefit from it. By contrast, the current Cypriot program is channeling huge economic rents into the hands of a very small number of beneficiaries, while at the same time creating distortions that discourage investment in other sectors of the economy. It needs to be ended immediately before further damage is done.